The U.S. China Economic and Security Review Commission 2011 Annual Report to Congress

by Dirk Ehnts

The U.S.-China Economic and Security Review Commission released its 2011 Annual Report to Congress on November 16, 2011.Below I discuss some paragraphs where I think the authors are mistaken in their beliefs.

China’s foreign currency reserves are skyrocketing. A major contributor to this phenomenon is China’s continued policy of maintaining closed capital accounts. China’s foreign currency reserves currently exceed $3 trillion, three times higher than the next largest holder of foreign currency reserves, Japan.

The accumulation of reserves has nothing to do with maintaining closed capital accounts, and everything to do with fixing the exchange rate at a level that allows China to run presistent current account surplusses. After all, other countries with skyrocketing dollar reserves like Brazil, the UK and Japan maintain open capital accounts. A closed capital account per se is not the explanation for the accumulation of reserves. It is only a piece of the puzzle, a piece that is not strictly necessary to complete the puzzle.

Commensurate with growth in foreign currency reserves, China’s domestic money supply is ballooning out of control. Between 2000 and 2010, China’s money supply grew by 434 percent. China’s money supply is now ten times greater than the U.S. money supply, despite the fact that China’s GDP is only one-third as large.

That is – ‘balooning out of control’?! Let’s run the numbers. China’s money supply that the authors look at is M1. Here are the numbers:

RMB 4.467,92 Mrd. Yuan (2000)
RMB 26.662,1 Mrd. Yuan (2010)

That is an increase of about 500%. Now is that balooning out of control? Let’s take a look at the quantity equation – for the sake of the argument – and see whether there is some truth to it.


So, money supply (M) times velocity (V) equals prices (P) times output (Y). If we assume some inflation, then a rise in M by 500% is roughly OK if output has risen at the same rate (including inflation). It would therefore be interesting to look at M/Y. That ratio was:

RMB 9.921,5 bn. yuan (2000), about 53.5% of GDP
RMB 36.526,5 bn. yuan (2010Q2), about 65.9% of GDP

This is hardly ‘domestic money supply is ballooning out of control’, especially when taking into account difference in use of money and, therefore, in the money multiplier. China’s households hold more money deposits, which many migrant workers then send home, whereas Americans prefer credit cards, which are not part of M1.

This does not mean that there is no inflationary pressure. What I want to say is that Chinese monetary policy differs fundamentally from US monetary policy, and that arguments that are probably OK with the Federal Reserve System are not so when dealing with the People’s Bank of China (PBoC) and the Chinese financial system. The latter relies on control via monetary aggregates, which is different from any inflation-targeting strategy. So, even when one excuses the authors mistake of accepting the myth that a rise of M1 leads to inflation…

… there is no reason to believe that high nominal growth rates in China must lead to inflation. The PBoC manages liquidity by using reserve ratio requirements, as I will show in a later post. This can stop inflation.

It is perhaps not surprising that the annual report to Congress is more about politics than about economics.

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